Should You Bet on Blue Chips? Maybe Not

We’ve all heard about “too big to fail”…but what about too big to succeed? In a recent letter, Research Affiliates discussed this very topic, and it deserves another mention.

The question: are large-cap, blue chip stocks a good deal…or are they really too big to succeed? The answer: It depends on who you ask. According to some fund managers, blue chips are a bargain. BlackRock Global Allocation Fund manager Dennis Stattman likes U.S. large-caps with global franchises (like Microsoft (NASDAQ:MSFT) and Johnson & Johnson (NYSE:JNJ)), with strong cash flows and attractive dividend yields (compared to Treasuries). Stattman told Bloomberg: “we can’t find a stock among the 20 or 30 biggest U.S. companies that looks expensive”. But does being cheap make them a good buy?

Yes…if you ask Legg Mason’s Bill Miller, who advised investors that they have a “once-in-a-lifetime opportunity” to pick up large cap stocks at the lowest prices in six decades. And Jeremy Grantham of Grantham, Mayo Van Otterloo & Co. expects blue chips to return three times more than large-cap stocks as a whole over the next seven years.

That would be quite a turnaround, considering that blue chips have trailed small and mid-cap stocks for the last decade, according to Bloomberg data. But there’s more to it than that. According to Research Affiliates, the stock that leads a sector tends to underperform the average by 3.5% the next year, and the next…and the next. Below are the largest holdings of some of the sector SPDRs.

They’re all large-cap, blue chips. Most are Dow components. And they’re all going to face challenges, according to the findings of the Research Affiliates study. Their conclusion: government spending negatively impacts these sector leaders.

Just how negatively? The study found the negative correlation between two years of increased government spending and the performance of leader stocks at -38%. And considering the Congressional Budget Office projections for the deficit ($1.3 trillion), it looks like some blue chip stocks are in for a tough road ahead.

BlackRock’s Statton expects blue chips to reward investors in the next two or three years. Well, never say never…but I’m not going to bet on it. Yes, there might be some attractive dividend yields, but small and mid-cap stocks will be a better opportunity for growth looking forward.

As for investing, take a look at iShares S&P SmallCap 600 Value Index (NYSEARCA:IJS): this ETF tracks the S&P SmallCap 600/Citigroup Value Index.

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